Why don’t the rich invest in index funds?

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Investing in stocks is a great way to increase your net worth, but it can also be a bit of a guessing game. Unless you have the knowledge, time, and patience to examine each individual company you are considering before buying its stock, you could end up with a portfolio overloaded with bad deals and underperformers.

This is one of the reasons why many investors tend to like index funds. These passively managed funds are designed to track the performance of a stock market index – typically by owning all companies in proportion to their weight in the index. The performance of an S&P 500 index fund, for example, should mirror that of the S&P 500.

This makes it a good option for people who want to simplify the investment process. You don’t need to research stocks one by one and you get instant portfolio diversification. (Case in point: Invest in an S&P 500 index fund, and you effectively invest your money in 500 of the largest US companies by market capitalization – which makes it a fair approximation of the country’s economy.) And index funds are also fairly inexpensive.

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When you invest in a mutual fund, you pay a set of annual fees that are in addition to its expense ratio. With a actively managed funds, what you get in exchange for this cost is the expertise of a seasoned fund manager and his team, who will put together a well-documented collection of stocks, put it into a neat package and change holdings fund when they see it is a smart idea.

It is not cheap.

With index funds, on the other hand, most of this work (and expensive expertise) isn’t necessary, so their expense ratios can be as little as one-tenth of what you would pay for an actively managed fund. But despite the many advantages of index funds, they are not particularly popular with wealthy investors.

Why the rich tend to look elsewhere

Index funds are an extremely profitable and convenient investment choice. But they generally aim to match the performance of their associated indexes, not to outperform them.

The ultra-rich, however, may not be happy with this. On the contrary, they might want to invest in a way that gives them the opportunity to beat the market, even if that means taking more risk in their portfolios – risks that they can tolerate much more easily than the average investor.

Imagine you have $ 400,000 invested in stocks from your tax-advantaged retirement accounts. That’s probably a lot of money for you, and if the value of your wallet were halved – or worse – it would have a major impact on your future quality of life.

But for someone with a $ 40 million investment portfolio, a large loss would still leave them very rich. This gives them the freedom to take more risk than the average retail investor will be comfortable with.

In fact, wealthy investors often prefer actively managed mutual funds, regardless of their higher fees – and their dubious chances of delivering that sought-after outperformance. In any given year, the vast majority of actively managed funds will not beat the market, and over periods of several years, their share decreases even more. In contrast, index funds often outperform funds active in different asset classes.

The wealthy can also more easily invest in real estate, antiques, and other less liquid assets – when you probably can’t afford the risk associated with buying a $ 50,000 piece of art. which you hope will appreciate its value. And in the “actively managed” sphere, the rich also have the ability to put money into hedge funds, which most of us are legally excluded from.

But even though index funds aren’t popular among the very wealthy, they are still a great choice for the everyday investor. If this is the category you identify with, it would be wise to add some to your portfolio. They may not make you rich overnight, but by capitalizing on the large, long-term gains in the US market, over time you could rack up a sizable amount and achieve your own financial goals.



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